This research analyzes the convergence properties of a discrete implementation of the Hull and White two-factor model. It compares caplet prices using both the discrete valuation algorithm and the analytic solution. Quality of the results depends crucially on the properties of the model parameters. The valuation algorithm may be improved while preserving its computational efficiency. An application of the modified algorithm to the caplet pricing problem indicates that substantially reduced valuation errors.

In addition to catastrophe and operational risks like e.g. the terrorist attacks on the World Trade Center airlines are exposed to substantial capital market risks. This study examines the cases of three major airlines including Lufthansa, United Airlines, and Qantas. Their risk profiles are analyzed with respect to commodity and exchange rate risks by applying the “Earnings at Risk”-concept to the profit and loss statements of the year 2003. Furthermore, potential hedging strategies are explored. It turns out that airlines are especially sensitive to movements of the oil price. However, hedges can provide (partial) protection against adverse movements of the risk factors.

This article analyzes spread ladder swaps traded by Deutsche Bank to several medium-size companies and municipalities. The value of these contracts is highly sensitive to correlations between forward rates. For a contract that was challenged by the medium-size company Ille at the Federal Court of Germany, it turns out that the derivative was originated at a negative market value of −90,000 to −115,000 euros (depending on the number of factors used in the model). Moreover, the model correctly predicts the range for the terminal payment after an adverse development of the term structure of approximately 567,000 euros. We also investigate a product feature that limits the upside potential from the viewpoint of the customer and show that it has a substantial impact on market values. According to the judgment handed down by the court, the bank should have informed the customer about the market value of the product in light of special circumstances. This raises questions as to which products must meet this requirement. Moreover, especially for exotic contracts, market prices are mostly model prices: for spread ladder swaps, substantially different prices are obtained even when investors agree on the variance/covariance matrix but disagree on the number of factors to apply in an implementation of a model.

This research analyzes tradingstrategies with derivatives when there are several assets and risk factors. We investigate portfolio improvement if investors have full and partialaccess to the derivativesmarkets, i.e. situations in which derivatives are written on some but not all stocks or risk factors traded on the market. The focus is on markets with jump risk. In these markets the choice of optimal exposures to jump and diffusion risk is linked. In a numerical application we study the potential benefit from adding derivatives to the market. It turns out that e.g. diffusion correlation and volatility or jump sizes may have a significant impact on the benefit of a new derivative product even if market prices of risk remain unchanged. Given the structure of risk investors may have different preferences for making risk factors tradable. Utility gains provided by new derivatives may be both increasing or decreasing depending on the type of contract added.